25 January 2013

Risk.net: New risk-free rate calculation for long-term guarantees test

The authority, which is overseeing the test that is due to start on Monday, has increased the credit risk adjustment that is applied to the three-month Libor rate that is used as the reference rate for the discount rate under Solvency II. Insurers will now need to apply a 20 to 35-basis-point deduction from the three-month Libor rate rather than the 10bp deduction that had been under the last quantitative test of Solvency II, QIS5.

Actuaries say that a divergence in overnight swap rates and three-month Libor rates since 2011 has led EIOPA to reconsider the credit risk deduction used to create the discount rate used to value liabilities under Solvency II.

The question of how to derive the risk-free rate is a long-running issue. There has been debate over whether the risk-free rates should be derived from the overnight rate, particularly following the decision for central clearing houses to base their calculations on the overnight rate. Overnight rates are seen as a better approximation of what is risk-free because they carry almost no credit risk. The problem is that the market in this kind of swap is neither sufficiently deep nor liquid enough to base the discount curve on. However, it would seem that the possibility that the risk-free rate would be based on overnight swaps seems to have been quashed for now.

Whether the final calibrations of Solvency will retain the higher credit risk deductions that will be used for the impact assessment is a concern for insurers. Bruce Porteous, head of Solvency II at Standard Life in Edinburgh, says: "We are content to use this new methodology for the impact assessment and expect to consult with EIOPA, after the assessment, on its ongoing appropriateness".

Full article (Risk.net subscription required)

© Risk.net